What happens next? Advice for the new President, part one.

Donald Vandergriff recommended speculating about what should be done by the new President. I avoid “if I were President” articles, but any advice by Vandergriff deserves serious attention. This is part of a series answering his question, describing a scenario under which the new President might take office –- a severe global recession — and the preparations he should initiate immediately after November 4. Part two discusses what the new President should do first, to establish moral leadership.

Before asking what the President should do, we must first sketch out the situation in January 2009 — or least, one scenario of the many possibles. This following is IMO a worst likely case (as in the standard presentation of 3 scenarios), and hence useful to illustrate what must be done.

US real GDP for 2009: down 4%, tied for 5th place with 1933 (bad, but nothing remotely like a depression).

World real GDP for 2009: down 1% (although we have only poor data, this is probably the worst since WWII).

Overall, the downcycle has continued the pattern since it began in December 2006: a sequence of surprises, weak links breaking in the global economic machinery (a network, not a china). Each unexpected, each snap increasing the stress on the remaining components.

Note: my forecast for the election is for an overwhelming win by the Democratic Party; see here for details.

Contents

Causes of the recession

Goals of the new President

Preparing to win

1. Causes

We can look at this on two levels.

First, the big picture. This macroeconomic shock is not a Black Swan event. I list here a few dozen of the hundreds of warnings that our course was certain to end on the rocks. That we ignore warnings and are astonished at the inevitable does make it a Black Swan event.

The primary cause is too much debt, as described here, and in pictures here. For centuries it has been common sense that taking on too much debt was imprudent and risks collapse and bankruptcy — for both individuals and nations. That people repeat such mistakes is one factor making history so dark.

To go one step deeper, this is a Thomas Kuhn-type paradigm crisis in economics. Aggregate debt levels are not considered a significant factor in Keynesian economics, so the massive rise in debt was not a concern of mainstream economists. “Austrian School” economists warned this was unwise, but they are a irrelevant minority in the profession. Some mainstream economists gave warnings, such as Maria Fiorini Ramirez in the mid-1980’s — but were ignored.

If we go deeper, there are reasons why we fecklessly accumulated so much debt. Weaknesses in our society, our patterns of thought. This downturn will fix some of these — an education for American, but an expensive one.

Second, what happened to the financial sector. While the event — long, painful deleveraging — was predicted, its effects have astonished even most of those who saw it coming. We have experienced at most a slight recession so far, yet our financial institutions have suffered damage in many ways like during the 1930’s. The organization and regulation of our financial sector was fundamentally flawed. Both will be radically changed. There are many alternatives. All we can say now is that the new system will be different, almost certainly with far greater government control in the allocation of capital within our society.

2. Goals for the new President

Realistic goals are a key to success.

Mitigate the suffering of Americans and other nations (through IMF aid) during the downturn.

Help the economy recover in 2010.

Prepare the foundation for a powerful recovery.

Manage the transition to a post-Empire world order.

Attempting to hold back the tide — remain a hegemonic power — guarantees failure, perhaps catastrophic failure. This downturn will shift power from the major nations of the post-WWII era (US, EU, Japan) to the rising states of Asia. Esp China. The transition from a hegemonic power — esp the US dollar as the reserve currency — to just another great power will require skill and wisdom. Success will benefit not just America but the entire world.

3. Preparing to win

The new President takes office with the clock running. A slow start might put his Administration behind the flow of events, as the Bush Jr. administration has been.

The President elect must select his team ASAP, and put them to work immediately. Planning and shaking down into a functional group takes time that they cannot afford after taking office.

The new President should learn from the example of Batman, rather than following the example of the Best and the Brightest in Vietnam as has the Bush Jr. team. Officials in the Johnson Administration were slow and reactive, always seeking to keep their options open (the very opposite of boldness), as have Paulson and Bernanke (see here for a discussion of this). Batman goes into a situation not with one plan, but with 12. A wide range of scenarios are considered and planned for. In the real world the actuals will be none of these, but the act of full-spectrum planning will better prepare them to react. Even more important, preparing for 12 scenarios forces openness to the possibility of extreme outcomes — a key to achieving a rapid OODA look in the face of unexpected events.

Afterword

If you are new to this site, please glance at the archives below. You may find answers to your questions in these, such as the causes of the present crisis. I have been writing about these events for several years; since November 2007 on this site. As you will see explained in these posts, the magnitude of the events now happening is beyond what most Americans have — or can — imagine.

Please share your comments by posting below. Please make them brief (250 words max), civil, and relevant to this post. Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

This paper introduces and describes a new dataset on banking crises, with detailed information about the type of policy responses employed to resolve crises in different countries. The emphasis is on policy responses to restore the banking system to health. … The database covers all systemically important banking crises for the period 1970 to 2007, and has detailed information on crisis management strategies for 42 systemic banking crises from 37 countries.

Governments have employed a broad range of policies to deal with financial crises. Central to identifying sound policy approaches to financial crises is the recognition that policy responses that reallocate wealth toward banks and debtors and away from taxpayers face a key trade-off. Such reallocations of wealth can help to restart productive investment, but they have large costs. These costs include taxpayers’ wealth that is spent on financial assistance and indirect costs from misallocations of capital and distortions to incentives that may result from encouraging banks and firms to abuse government protections. Those distortions may worsen capital allocation and risk management after the resolution of the crisis.

Institutional weaknesses typically aggravate the crisis and complicate crisis resolution. Bankruptcy and restructuring frameworks are often deficient. Disclosure and accounting rules for financial institutions and corporations may be weak. Equity and creditor rights may be poorly defined or weakly enforced. And the judiciary system is often inefficient.

… Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery. Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies.

… Fiscal costs, net of recoveries, associated with crisis management can be substantial, averaging about 13.3% of GDP on average, and can be as high as 55.1%of GDP.

… This paper presents a new database on the timing and resolution of banking crises. The data show that fiscal costs associated with banking crises can be substantial and that output losses are large. While countries have adopted a variety of crisis management strategies, we observe that emergency liquidity support and blanket guarantees have frequently been used to contain crises and restore confidence, though not always with success.

For more information from the FM site

To read other articles about these things, see the FM reference page on the right side menu bar. Of esp interest these days:

16 thoughts on “What happens next? Advice for the new President, part one.”

“Even more important, preparing for 12 scenarios forces openness to the possibility of extreme outcomes — a key to achieving a rapid OODA look in the face of unexpected events.”

If handling extreme outcomes is the capability we’re looking for, then the worst-case assumptions for GDP and unemployment should be more dire to prompt more extreme solutions. Some suggestions:

How to solve 25% unemployment in the US? How to deal with a destabilized Mexico? How to pay interest on the national debt if 30-year T-bond yields spike past 20%? How to do all of the above while more Baby Boomers start claiming their entitlements? Has either candidate (or their chief strategists) read “The Defense of Duffer’s Drift”? It is an excellent introduction to the habit of rapid-fire scenario development.
.
.Fabius Maximus replies: Everyone has their own taste in what “extreme” means. Mine is extreme vs. consenus forecasts, almost all of which expect GDP growth for the US in 2009 — and all of whom expect GDP growth for the world in 2009. And I consider 25% unemployment too unlikely to be a worthwhile planning scenario at this time.

As I mentioned in the post, a destabilized Mexico is easy to imagine a likely consequence of my worst case scenario.

The problem is the government is not a think tank staffed with experts, but a front-office representing special interests and consituencies. There is really no single “brain” there, only multiple ears waiting to hear what their clients want.

Try to imagine what an oval office meeting must be like — if you’ve ever been in an academic senate meeting, you’ll have some idea of how hard it is to come up with anything coherent, much less creative.

Despite the exhilarating shocks going around the financial world, and tantalizing spectres of government control of banks and lending, I am pretty sure we will stumble forward in the old paradigm, led by the old players.
.
.Fabius Maximus replies: (1) The government does have ample “think tank” capabilities, down in the bureaucracy — althought it is too seldom tapped. (2) There is ample biographical and autobiographic data showing that plans and solutions to serious national problems are seldom developed in the Oval Office, but by staff in the relevant agencies (or NSC, etc). (3) These “motion is impossible” proofs are fascinating, but nonetheless American history has many instances of major personnel and policy changes — usually in times of crisis. Like now.

Following your prediction of a lopsided Democratic win in November, what concrete steps should (presumptive President Obama take? Your points in #2 above (Goals for the New President) are vague. Do you have anything more prescriptive, not to mention specific? “Help the economy recover in 2010,” for example is so nebulous to as to be useless, without specific steps. Everyone wants to help the economy recover; so what? What steps will you take?

Now, I understand that the incoming President will have a less-than-ideal sellection of politicy options from which to choose, but given those… make a choice.

Do you encourage the fed to cut interest rates, perhaps risking inflation, but injecting liquidity into the economy? Do you cut taxes, hoping to encourage bunsinesses to undertaken new projects in the US. as opposed to elsewhere, places with a better tax-and-expense environment, such as perhaps Ireland? Or may be you opt to raise taxes to better balance the deficit and fed budget. Will cosummers, thus chastened, still buy consummer goods freely, not to mention big-ticket items like cars and trucks, needed to revitalize our system.

On energy, do you push for best-possible speed wind and solar power, and the like, even though these are years from weaning us off foreign oil. Do you opn up development of LNG domestically, per T Boone Pickens, and maybe allow oil drilling off our shores, since the Chinese are already doing it anyway within sight of Florida! What about nuclear power; the French has used it for years w/o incident; why can’t we? Ditto the US Navy, which has used nuke vessels for years very successfully for missions around the globe.

What programs will have to be cut to pay for the items above? It is either that, or raise taxes, or spend at a deficit, digging a deeper hole. We could print money, which is inflationary.

Well, one could start with the DOE; the federal/state education bureaucracy spends a frightful ammount of money/pupil but results still stink. Force a 60-70% reduction in the number of administrators, most of whom suffle paper and accomplish nothing relevant to teaching or classmrooms. Why should a district superintendent make over 200K a year, for a job that is largely a figurehead position?

Next, get rid of DHS; this agency was created in the panic after 9-11, and all is has done is add a layer of complexity to the national security apparatus, which was already big and ponderous enough,

Some ideas: Withdraw from Iraq unless the Middle Eastern Powers in play, Saudis, etc. oay for our costs of being there, No cost, US goes home (maybe leaves a tripwire force there and some airbases) Afghanistan- greater NATO participation and payment, with drawdown of US forces and costs. Again, if anyone wants us to play, they gotta pay, absent real US needs in the region.

Cancel high-dollar unneeded projects such as the next group of nuc subs, or perhaps shealth aircraft, which offer limited unility for their cost. Build more F16s, F18s, instead; the F-22 and F-35 are too expensive but for small numbers. We need ground attack AC and tankers also.

Gradually abolish pensions for retired military personnel, those begining after 20 years of service. Keep the existing plans, but do not allow collection until age 65 or even 68-70. IT is financially unstsustainable for the taxpayer to pay for 30-35 year long retirements (some at generous officers benefits), multiplied by millions of veterans. Begin phasing in a decent pay package for the lowest E-1, and insist that he save his own money, Get rid of refined benefit pension plans which are going the way of the dodo bird all around us, and can’t be sustained. Perhaps make the main selling point of long service the chance to win govt.-funded healthcare for life, still a decent reward for service. The above also apply to fire fighters, police, and other federal and state personnel, as well as tradesmen promised a generous pension.

To decrease the legacy payments weight upon us from Social Security, Medicare, Mediaide, we have to means-test (see if applicants make above a certain level of income before getting benefits), and we also have to insist in greater copayments, even this means seniors getting back into the workforce. We are living longer and have to pay the piper somewhere. There may have to be some sort of rationing of care; that not all of us can afford the latest $250,000 diagnostic machine, or perhaps the latest surgery. Establish a basic level of care, a floor, as a “right” but successive levels up that must be bought somehow, and have additional costs.

That’s all my ideas for now… let me know your additional ideas…
.
.Fabius Maximus replies: As I said, all that in a later post. The “mental game” changes are the important ones, IMO. They position the Administration for the policy changes.

A reminder that the comment policy is “brief, 250 words max.” At 788 words, this is the length of a post — not a comment.

I think that Batman should consider this extreme option, too: U.S.A inability to pay its debt, and coinage of a New Dollar. The Laboratoire Européen d’Anticipation Politique (www.europe2020.org), a French think tank which accurately forecasted the development of this crisis since 2005, makes this prevision.
.
.Fabius Maximus replies: Unfortunately this is not an extreme outcome, IMO — but a likely one. That we cannot pay out debts is a fact; the question is will the US still have easy access to cheap loans? I discuss this in “Effective treatment for this crisis will come with ‘The Master Settlement of 2009’.”

FM: “Attempting to hold back the tide — remain a hegemonic power — guarantees failure, perhaps catastrophic failure. This downturn will shift power from the major nations of the post-WWII era (US, EU, Japan) to the rising states of Asia.”

Well, if we’re thinking worst case, we should certainly include: 1) reduction in US military, and 2) Iran develops a nuke, and 3) terrorists get a nuke (from Iran, N. Korea, or Pakistan; or parts from each), and 4) Tel Aviv is nuked.

I consider this catastrophe more likely than a full year of -4% GDP. But even more likely, and less talked about, is 1b) Israel attacks Iran to stop Iran from getting a bomb, with 2b) Russia allying with Iran, and 3b) the US allying with Israel and getting dragged (or jumping?) back into Iraq/ Iran.

You often allude to how WW II stopped the Depression — nuclear ME War 2011 would make the financial problems look small in comparison. And it is fear of the above that means whoever wins in Nov will give us Bush 3 in the Middle East after Nov.

(Though current US development aid for building can easily be changed into local municipal or national bonds for development, backed by future oil revenue, even at $80 – $50 / bbl.)
.
.Fabius Maximus replies: I don’t understand much of this.

(1) The sequence of events you describe is not logically related. Iran can develop a nuke no matter what we do to the US military budget (note Obama advocates increasing manpower). Ditto terrorists getting nukes. Iran nuking Tel Aviv I consider a fantasy, with near-zero likelihood. Terrorists doing so, but again there is little evidence that this is likely in the next few years.

(2) A 4% GDP decline is a likely event based on history of banking crises in Japan, Sweden, Asia, and UK. The recent IMF study said that the average resulting downturn lasted 15 quarters and took GDP down 5% (peak to trough). This is the context for my “worst case” of -4% in 2009.

FM shows an admirable calmness in looking into the future. I can’t take my gaze off the amazing spectacle unfolding in the present — old financial firms collapsing overnight, governments reversing course daily, conservative leaders talking about the death of capitalism, monstrous spectres like the $65 trillion pyramid of CDS swooshing through the night-time skies — whew!

It’s not reasonable to speak of a Kuhn-type paradigm crisis ever occurring in economics – not until it matures as a science, not unless you’re just being metaphorical. A necessary precondition for a shift in that sense is the existence of one accepted paradigm, not merely that there is a paradigm in power and widely adapted by policy makers. In a pre-scientific field there is no widely accepted paradigm. The gap between, say, Keynsian thought and Austrian won’t be found in any parallel in a hard science. This is more on the order of flat-earth vs round-earth. Once experiments showed the earth to be round, flat-earthers – except for our modern kind – fell away and adopted the new paradigm. But in the 6-billion body problem of economics no experiment can yet be definitive, even one that rocks our society and costs us a few trillions in wealth.

In terms of the ascendancy of one economic belief system over another you may well be right – but doesn’t it seem to you that economic idealogues show an astonishing level of commitment to their beliefs well beyond what is justified by the evidence? That’s not a hallmark of honest science. Science knows nothing of the religious fervor of the Austrians nor the mysticism of thre classical Keynsian.
.
.Fabius Maximus replies: I do not understand. Why does Kuhn’s theory require a science to be mature? He speaks of science as a community, with no reference at all to the validity or utility of its beliefs. It is a description of sociological processes, working just as well for para-psychology as physics. Some of Kuhn’s comments about the nature of truth make me wonder if believed the difference between the two was significant.

Also, why does economics not have “an accepted paradigm”? In what way does Keynesian theory not fit Kuhn’s description?

Lacking maturity something that wants to be a science lacks a body of consensus. Among physicists, while there’s a lot of lively discourse, 99.9% of the facts are agreed upon and settled. So Newtonianism was a paradigm in that everyone agreed on almost everything, and it was upset by relativity. And because physics is a science, after a lot of groaning and quibbling everyone recognized Newton’s physics as a special and limited case in the context of a new big picture. It’s that shift in consensus that marks the adoption of a new paradigm, and it’s the capacity for such a shift that distinguishes a science from a bar-room brawl – like economics. Kuhn paints with a broad brush, but it’s safe to say that scientific revolutions only occur within science.

If economics has an predominant paradigm, what is it? Do the vast majority of economists subscribe to Keynes beliefs? Will they be shredding their papers now and studying the German they never used to need? Or next year or ten years hence? That’s what a paradigm shift looks like.

Personally I see the bulk of economics – again in the sense of major schools of economics – as less of a science and more of a field of rule-of-thumb policy engineering. Predictitions – yes, god help us, help your self to some more. Quantitative, repeatable, testable predictions? Nope.

I think I used the term “paradigm” first in this thread — and not very carefully. I was not referring to an economic theory or ideology (like “free market”, or “neo-liberalism”), but the old way of doing business, in which Wall St, or finance Capital, vets the candidates, staffs the Treasury, issues the currency, sets the discount rate, funds the think tanks, writes the regulations, and plucks out profits wherever it can, without regard to public well-being.
.
.Fabius Maximus replies: It is a word with many uses. I used it first — in the post. As I said, a “Thomas Kuhn type paradigm crisis”, as explained in “The Structure of Scientific Revolutions” (one of the great works of the social sciences, IMO).

I would like to know where Fab finds the time to do all this. He keeps coming out with idea after idea and still has time to comment to each respondent. FM must be either retired or unemployed. If he had a day job and a family, he would be too busy to run a forum like this. Hats off to a singular exemplary effort.
.
.Fabius Maximus replies: This is just a secondary hobby. After one inserts the ship into the bottle and sets the masts, there is little to do while the glue dries. That provides the time to rap these out. There is, however, too little time for any proofreading.

FM, I would suggest ways to dry the glue faster… dehumidifier, hairdryer etc. but then we’d be deprived of your initiative here.

I think you’ve sketched out the basic prongs… I would say things to watch for is Obama moving fast in November to assemble a team on the economic side, and watch who they are… also, there will be I think an austerity message and a call to engagement and national service and sacrifice before the Inauguration… a welcome change from the prior strategy of funding foreign adventurism on borrowed money and telling the plebes to go shopping… did that really happen in this country?

Presuming your figures, unemployment is going to be an issue… for now I am with Krugman that inflation be damned, we need public works, infrastructure, rebuild in preparation for a recovery.

Of course there will be the wonderful moment of seeing Bush’s pardon list… will he pardon himself? Chaney? Rumsfeld? etc… And will they, like Kissinger, not be free to move about the planet?

Something also tells me, and this could be wrong, that at some point Obama will find out some very dire news about oil and energy… and why we are really in Iraq, and why we are almost fetishistically being so strange about Iran.

I forget to mention chopping wood. I am almost done for the year, with five cords out back. Mostly cut by hand by me. We keep the furnace’s thermostat at 60 during the night, which reduces the amount of wood we burn.

Without the hours spent doing that I could do a better job on this site.

“The organization and regulation of our financial sector was fundamentally flawed. Both will be radically changed. There are many alternatives. All we can say now is that the new system will be different, almost certainly with far greater government control in the allocation of capital within our society.”

Apart from government funds being used to defend balance sheets against default – and probably a lot of arm-twisting and back-room counter-party balancing of the massive amount of unregulated derivatives flying around – I do not yet see evidence of the above. The fact that an unregulated version of ‘free markets’ has gotten wildly out of whack does not necessarily mean that we will swing back to an extreme socialist model. Yes, people keep talking about it, but thus far the American response to the crisis seems to have been to do everything possible to maintain the banking sector as is (including the corporate-owned Fed and the Goldman Sachs run Treasury).

Indeed, I think the big risk here is that apart from fixing the lack of regulations in the uber-derivatives market (I bet they don’t eliminate them) that in fact there is a further tightening of corporate sector control. Indeed, one can almost make the case that the more government is involved that much more the corporate sector is in charge since their influence on major policy on all fronts has never been stronger and has been increasing steadily for decades.

Far from heralding a new shift or radical change, this whole debacle might even end up being a sort of hidden coup for further consolidation of the same underlying, and highly unsatisfactory, paradigm.

I sense that Obama would actually like to bring things back down to a more sane, ordinary and principled level. But it is unlikely he will have any major influence on deeply entrenched powers that be in Washington and beyond. He is also not populist enough to use the bully pulpit effectively once he is no longer an outsider fresh face calling for the change the entire country knows is needed. But will not get.

Above I posted: “Far from heralding a new shift or radical change, this whole debacle might even end up being a sort of hidden coup for further consolidation of the same underlying, and highly unsatisfactory, paradigm.”

“The United States has indicated its willingness, for the first time, to discuss creating an international governance structure for financial markets, a top European Union official said on Friday.

With lead European dog ex-Mossad helper Sarkozy leading the charge from across the pond, clearly this is where we’re headed. As Ralph Nader’s Dad told him one day: ‘capitalism will always come out ahead because when they mess up they get socialism to bail them out.’

No need to worry about going socialist. As Plato said, I heard: ‘democracy is the step that leads to oligarchy’. Russia has been kicking hers out, but we are just entering the phase of full spectrum dominance.
.
.Fabius Maximus replies: Modern capitalism and socialism have been in existance for aprox 150 years. Do you have any examples of socialism “bailing out” capitalism?

Also, I do not believe this is an accurate representation of Plato. Wikipedia, as usual with this sort of noncontraversal info, express it well:

{In The Republic Plato} “discusses five types of regimes. They are Aristocracy, Timocracy, Oligarchy, Democracy and Tyranny. Plato also assigns a man to each of these regimes to illustrate what they stand for. The tyrannical man would represent Tyranny for example. These five regimes progressively degenerate starting with Aristocracy at the top and Tyranny at the bottom. Each regime below aristocracy is worse than the one before. Aristocracy is considered the best.”

The common quote from The Republic about democracy, liberty, and tyranny:

“Democracy is undone by the same vice that ruins oligarchy. But because democracy has embraced anarchy, the damage is more general and far worse, and its subjugation more complete. The truth is, a common rule holds for the seasons, for all the plants and the animals, and particularly for political societies: excess in one direction tends to provoke excess in the contrary direction. … So an excess of liberty – in the state or in the individual – seems destined to end up in slavery”

Sorry I missed, I have been very busy. I have a book out next week, and then a chapter (with in an Anthology posted in three weeks). My work is spreading rapidly, especially after the Army CSA passed out an excerpt to the next book (entire chapter on how we should train) to every 2 star in the Army.